How to Avoid A Wipe Out When Trading

By ,

What was your childhood dream?

Maybe it was to play cricket for Australia, or blast off into outer space. Or maybe your sights were set on the blaring siren and flashing lights of an emergency vehicle.

For me, it was flying. Nothing else came close.

I remember gazing out a plane window as a five-year-old. I was amazed at how the cars and buildings below looked like toys. It’s one of my most vivid early memories.

For years I built model planes and read aviation books. I’d also pester my dad to arrange a cockpit visit every time we flew. I simply couldn’t get enough.

Things began to change in senior school…

While my passion to fly was still strong, the stock market had my imagination. The cockpit was destined to remain a childhood dream, or at least that’s what I thought.

You see, I recently had the chance to step back in time. My son’s Scouts group had an excursion to a flying school. And I quickly put up my hand to help out.

The day involved introductory briefings and a walk around the hangers. But the highlight was a 30-minute flight in a single engine Cessna. I was back in a cockpit for the first time in years.

So, did I recapture the flying bug?

Well, my mind was racing listening to the instructor. I thought maybe I could still do this.

But the flight put an end to that idea. As fun as it was, I knew I wouldn’t take the next step. My enthusiasm for being in a hot, noisy cabin just wasn’t what it once was.

The experience was like a window into another life. My career could have easily begun that way. It’s the closest I’ll get to going back in time — even if it was just for a few hours.

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Would you play it safe or leverage up with CFDs?

Unfortunately, time travel remains the realm of science fiction. We can only guess what might have been if we’d made different choices at life’s key moments.

But let’s pretend for a moment.

Rather than winding the clock back, let’s look forward three years.

Suppose you knew that the gold price would rise 90% by 2021. This isn’t speculation, it’s a sure thing. You have 100% certainty that gold will nearly double in value.

How would you use this information to make the most money possible?

Now, there are many ways you could trade this knowledge.

But I’ll narrow it down to two choices:

  1. You could buy gold outright; or
  2. You could use a CFD (Contract For Difference) to get leverage.

Before you decide, have a look at this:

MoneyMorning 14-12-18

[Click to open in a new window]

This is a real chart of the gold price from an earlier time.

But for today, I want you to imagine it’s showing you the future. Don’t worry about the big chunk of data missing. I’ll tell you why I’ve covered it up in a minute.

Now, suppose you can buy gold at $1,000 (where I’ve marked on the chart).

And you know you can sell it for $1,900 in December 2021.

How much would you buy?

Remember, there are two options:

  1. Buy gold outright; or
  2. Use a CFD to get leverage.

CFD provider IG has a product that will give you leverage of 100 to 1. This means for every dollar gold moves, your account’s value changes by $100.

For instance, if you buy one CFD when gold is $1,000, and sell when it’s at $1,900, you’ll pocket $90,000. That’s the power of leverage.

Now, think for a moment…

The price rise is a certainty.

Do you play it safe or leverage up with CFDs?

Just for fun, work out a hypothetical trade. Use your capital base to decide how much gold, or how many CFDs, you’d buy. It will be interesting to see how this plays out for you.

The key is to trade conservatively

OK, let’s fast forward three years.

Check this out:

MoneyMorning 14-12-18

[Click to open in a new window]

There’s no surprise with the result — gold hits $1,900 on schedule.

If you’d bought the yellow metal outright, your account is up 90%.

But what if you chose the CFDs?

Well, you’re potentially up $90,000 per contract. It doesn’t take much maths to calculate some big numbers. You could be ahead by over a million dollars with just a dozen CFDs.

There’s just one question: Were you able to hang on?

Yes, you knew gold would hit $1,900 — that was never in doubt.

The only problem was, you didn’t know what course it would take.

Look at the decline following the entry point. Gold falls by over $300 per ounce.

Now, this isn’t an issue if you bought gold with capital sitting in your account. You know the fall is temporary. So you just ride it out and wait to collect.

But it’s not so simple if you’re using leverage.

You see, the CFD provider adjusts your account daily. It adds money when the price rises, and makes withdrawals when it falls.

Do you remember the amount of leverage on the gold CFD?

Let me remind you — it’s 100 to 1.

Here are the sums on one contract…

Every dollar gold moves creates a $100 adjustment to your account. If gold falls $10, the CFD provider withdraws $1,000. If it falls $100, the withdrawal is $10,000.

In the example, gold drops to $681. That’s a fall of $319. Multiply that by 100 and you get a loss of $31,900. And that’s for just one CFD. How many contracts did you think of buying?

The CFD provider will allow you to keep the trade as long as you can cover the loss. If your account runs out of funds, it’s all over. The trade gets closed. All you get to keep is the loss.

Even knowing the future doesn’t guarantee a profit when using leverage.

The simple fact is this: You can be the world’s best trader and have a heap of capital. But you still run the risk of ruin if you use too much leverage.

The key is to trade conservatively.

Keeping your trade size under control is the best way I know to avoid a wipe out.

Until next week,

Jason McIntosh,
Editor, Quant Trader

PS: In this just released report, Matt Hibbard shows you his top five dividend picks for 2019. Click here to claim your copy today.

About Money Morning Editorial

Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the…

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